§ The Interest Tax Shield with a Target Debt-Equity Ratio
§ Rather than maintain a specific level of debt, many firms target
a specific debt-equity ratio
§ In this case, first compute V
L
and V
U
:
V
L
= PV of free cash flows discounted with the WACC
V
U
= PV of free cash flows discounted with the pretax WACC
§ The value of the interest tax shield is V
L
– V
U
§ Recapitalization – a significant change to capital structure
§ Leveraged recap – using debt proceeds to pay dividends
or to repurchase shares
§ Ex) Midco has 20 million shares outstanding with market
price of $15 per share and no debt. The tax rate is 35%
§ If Midco borrows $100 million permanently and
repurchases shares, what will happen?
§ The Tax Benefit
§ V
U
= 20 million shares * $15 per share = $300 million
§ PV(Interest Tax Shield) =
t
c
* D = 35% * $100 million = $35
million
§ V
L
= $300 million + $35 million = $335 million
§ E = V
L
– D = $235 million
§ Value of shares outstanding will decrease from $300 to $235
million, but equity holders will also receive $100 million
through repurchases
§ The Share Repurchase
§ If Midco repurchases its shares at the current price of $15, it
will repurchase 6.667 million shares
§ There will be 13.333 million shares outstanding after the
repurchase
§ The new share price is $235 million / 13.333 million
= $17.625
§ Would any investor sell their shares at $15?
§ No Arbitrage Pricing
§ Once investors know the repurchase plan, no-one will sell at
$15
§ The share price will rise immediately to a level that reflects
the $35 million value of the interest tax shield
§ With 20 million shares outstanding, the share price will
immediately rise to
$335 million / 20 million = $16.75
§ This is the lowest price at which Midco can repurchase shares
§ No Arbitrage Pricing
§ When securities are fairly priced, the original shareholders of
a firm capture the full benefit of the interest tax shield from an
increase in leverage
§ Do firms Prefer Debt?
§ When firms raise external funds, they tend to prefer debt
§ Total equity outstanding has decreased, meaning firms are
repurchasing
§ Capital expenditures exceed external financing, which
implies that most investment and growth is supported by
internally generated funds
